Palo Alto: Ample Potential But Masked Out Of Sight

In my piece on CIBR, I took a look at the cybersecurity industry as one of the most interesting investment cases in the IT sector. I am bullish on cyber prospects both in the short and long term, and I believe that Palo Alto Networks (NASDAQ:PANW) is the best tool to skim that cream I was writing about. The company published strong prints for the second quarter of 2023, with all major indicators going beyond expectations. Over the past 10 quarters, Palo Alto's top-line growth has not fallen below 20% YoY. I expect PANW to continue to outperform the industry, given its global market leadership and sustainable cyber tailings.

Strong outlook and financials

The modern cybersecurity threat landscape is constantly evolving, with new vulnerabilities and zero-day attacks discovered continuously. Against this backdrop, the implementation of the Zero Trust model could be the starting point for corporate network security. The combination of Prisma SASE, Cloud and CORTEX solutions positions the company well to effectively meet the next-generation cybersecurity system rollout. In particular, the new remote access deployments carried out by ZTNA could reach 70%, compared to just 10% in 2021, which suggests a significant growth in this area.

At the same time, Palo Alto continues to grow its presence in the market, where the company increased its share to 7.9%. However, the completion is stepping on the heels. Cyber products are expected to increase by 11.7% in 2023, which is more than 2x on top of the IT industry. I will share some thoughts on this from my piece on KIBR:

The outperforming growth of the cyber industry is broadly in line with software spending (+11.3% in 2023), which should now take over, following the strong growth of data center systems last year.

Looking at the patterns, Palo Alto's revenue growth rates have not fallen below 20% YoY for the last 10 quarters, moving relatively in step with Fortinet (FTNT) and well above Cisco (CSCO) and Check Point (CHKP).

Obviously, Palo Alto underperformed CrowdStrike (CRWD) in terms of revenue momentum, as Endpoint security is the fastest-growing category thanks to the rapid deployment of cloud infrastructure. And while the CRWD is experiencing a downward pattern, the PANW is holding on to consistency. With this, we are moving to the point where Palo Alto is well ahead of its competitors in terms of portfolio breadth, covering most of the existing cybersecurity solutions. The recent quarter showed 25.7% YoY growth to $1.7 billion and GAAP positive EPS of $0.25, where both lines came on top of expectations.

I believe PANW could grow at a mid-20s rate going forward in FY2023-24, as the company has a potential to further lead the market and increase its market penetration. In my view, it’s quite reasonable to expect, due to the comprehensive product range which set up Palo Alto to dominate in the industry, tilted to consolidation of cybersecurity solutions.

In particular, there has been a clear trend towards provider consolidation on the part of consumers of cybersecurity products, hence the rejection of heterogeneous solutions from different vendors. This is in order to bypass problems with the integration, as the new products are becoming more complex, and for reasons for cost optimization as well. The trend is clearly evidenced, when in the second quarter the number of large clients that bring the company revenues of more than $1 million were up by 19% YoY, while the number of contracts worth more than $5 million surged by 84% YoY.

Moving forward, in the context of a slowdown in the global economy, enterprises continue to have an increased interest in cybersecurity solutions. Information security remains a priority for those that have entered the path of digital transformation. And despite the turbulence, organizations' spending on cybersecurity is fairly resilient, which is supported by the fact that Palo Alto's order book and active contract liabilities are currently growing at a faster rate than revenue. In Q2 2023, current orders increased by 26.2% YoY to $2 billion, while the volume of obligations under existing contracts grew by 38% YoY and stood at $8.8 billion, which exceeds the company's 2022 annual revenue.

My favorite point is that Palo Alto perfectly combines features of growth and value companies, balancing double-digit revenue growth, operating efficiency improvement, strong free cash flow generation, investments and shareholder payouts. All these without hurting margins and leverage. In particular, Palo Alto aims to achieve up to $6.9 billion in revenue for FY20223, thus performing well above the 20% growth line, and to reach up to $9.2 billion in current orders. The management also predicted an expansion of adjusted operating margin by 200bps to 37.5%. Overall, Palo Alto manages to control rising operating costs and even reduce the administrative cost burden to 4.5% of revenue in Q2’23, despite the vast majority of tech corporations reporting declining margins. And although the figures of adj. EPS and adj. FCF lagged behind revenue growth due to investments, the current focus is to turn that strong top-line growth more profitable.

The company already almost doubled its FCF in the recent reporting quarter on a YoY basis to $656 million, which could power the available authorization for the buyback program in the amount of $750 million, or 1.3% of capitalization.

Upside hidden in plain sight

Comparing the valuation of the PANW to the peer group, the company’s P/S ratio of 9.9x (on TTM basis) levels among the highest. In my view, the P/S ratio is most suitable here, as the company has a decent top-line growth potential. The peer’s median P/S ratio of 6.9x implies a 44% premium over the selection and could suggest a significant overvaluation of PANW stock.

However, I would rather look at the P/S ratio through the prism of the analyst’s future revenue growth expectations.

Boom! It’s not that expensive. We could find PANW’s spot clearly on the trendline, which suggests that the 25.4% FWD growth prospect is justifying the company’s P/S valuation at 9.9x. As a result, it appears that Palo Alto well deserves to be valued at a 44% premium to the competition, implying that the stock is fairly valued. Yet, we are still not there.

Let’s now divide the P/S ratio to future revenue growth outlook in order to get a more quantitative picture of how Palo Alto ranks amid the competition, and obtain the fair value estimate.

Summarizing the above calculations, Palo Alto is trading at a PS/G ratio (which is equivalent to the PEG ratio, while using PS and FWD sales growth) of 0.39x, compared to a 0.47x median level for the peers. This suggests that PANW is trading at a 15.8% discount on P/S compared to competition when taking into account the future sales growth prospects. And in order to arrive at the fair value, we should take a reverse movement. In particular, by multiplying the median PS/G (0.47x) with the company’s growth outlook (25.4%), we could obtain an 11.8x P/S ratio. Applying the TTM revenue (not FWD, because the future revenue growth is already priced in the calculation of PS/G) of $6.2 billion to the latter multiple implies a target capitalization of $72.7 billion, or $240 per share, and suggests a 24% upside potential.

Based on the valuation, I assign a Buy rating to Palo Alto shares. In my view, it’s reasonable to expect a 20%+ upside risk, as the company has a strong blend of hardware and software to address the active migration to hybrid and multi-cloud network environment; big data; and IoT growth drivers for cybersecurity solutions. Moreover, there will also be a focus on AI risk management, following the active implementation of AI technologies. In particular:

More than 40% of organizations face privacy and security breaches in the implementation of AI projects. Thus, businesses can't afford to cut security expenditures as this would leave them vulnerable.

Building on the results of 2Q, Palo Alto raised its forecasts for all key indicators for FY2023, which is encouraging. Also, the company is actively growing through entering deeper into the customers' wallet share, as well as purchasing market share. Back then, the latter turned out to be a lucrative bet, which helped PANW to concur a global recognition and extend its product offerings.

Risk factors

And yet there are certain downside aspects. The constrained budgets suggest a haircut to technology spending, which is reasonable to expect to some degree. The inflation and interest nooses may temporarily put on hold the introduction of information security systems, but in the future, the projects should resume anyway. At the same time, there are practically no refusals of contracts.

Takeaway

Despite the macro turbulence, the business consumption of cybersecurity solutions remains intact. I am bullish on the company’s prospects and, in my view, there is a resilient potential to perform in the 20-30% growth band. The appearance is an obvious high valuation, but if we walk the P/S ratio through the PANW growth potential against the competition, a decent upside potential could be hidden in plain sight.